Externalities

Question 1

Positive externally in consumption

Answer 1

• If left to free market, consumers will underconsume merit goods
• Because the benefit to the individual consumer is less than the benefits to society (therefore MSB>MPB)
• Creates a marginal external benefit, equal to the distance between MSB and MPB
• and a welfare loss from Q(fm)-Q(so)

Question 2

Negative externality in consumption

Answer 2

• If left to the free market, consumers who will overconsume demerit goods
• Because the benefit to the consumer exceeds the benefits to society (therefore MPB>MSB)
• Creates a negative marginal external benefit, equal to the distance between MSB and MPB
• And a welfare loss from Q(so)-Q(fm)

Question 3

Negative externality in production

Answer 3

• If left to the free market, producers will overproduce negative production externalities
• Because the individual firm will only take into account its own private costs and not those of wider society (therefore MSC>MPC)
• Creates a marginal external cost equal to the distance between MSC and MPC
• And a welfare loss from Q(so)-Q(fm)

Question 4

Positive externality in production

Answer 4

• If left to the free market, producers will underproduce positive externalities in production
• Because the individual firm will only take into account its own private costs and not those of wider society (therefore MPC>MSC)
• Creates a negative marginal external cost equal to the distance between MPC and MSC
• And a welfare loss from Q(fm)-Q(so)